A company can post record profits and still miss payroll. The financial statements, the auditor's verdict on them and the filings that make them public let you spot that gap before a client's money goes in.
When you recommend a stock or a bond, you are betting on a business you will never walk through. Its financial statements are your view inside. The income statement asks whether the company made money. The balance sheet shows what it owns and owes, and the cash flow statement tracks the actual cash. Public companies prepare all three under generally accepted accounting principles (GAAP), the U.S. rulebook for financial reporting. That shared rulebook lets you compare one company with another.
The income statement reports results over a period of time, such as a quarter or a fiscal year. It starts with what customers paid and strips away costs one layer at a time. Learn the order, because each subtotal tells you something different:
- Revenue less cost of goods sold (COGS) gives gross profit. COGS is the direct cost of making or buying what was sold.
- Gross profit less operating expenses, including selling, general and administrative costs and depreciation, gives operating income, also called EBIT (earnings before interest and taxes).
Common mistakes
- Wrong EPS inputs: Dividing Bayview's $1,400,000 by 1,100,000 year-end shares gives $1.27, and skipping the $100,000 preferred dividend gives $1.50. The correct basic EPS is $1.40, and common dividends never enter the calculation.
- Book value traps: Dividing by 1,150,000 issued shares instead of 1,100,000 outstanding gives $9.57. Leaving the $1,000,000 of preferred in equity gives $10.91 instead of $10.00.
- Cash flow signs: Depreciation is added back, not subtracted, and a rise in receivables is subtracted, not added.
Bottom line
- Income statement order: revenue − COGS = gross profit; − operating expenses including depreciation = EBIT; − interest = pretax income; − taxes = net income; − preferred dividends = earnings available to common.
- Basic EPS = earnings available to common ÷ weighted average common shares; diluted EPS adds convertibles, options and warrants and is never higher than basic.
- Balance sheet: assets = liabilities + equity on one date; working capital = current assets − current liabilities; book value per share = (equity − preferred) ÷ common shares outstanding, which excludes treasury stock.
- Cash flow statement: operating (net income + depreciation, adjusted for working capital), investing (property, equipment, investments), financing (debt, stock issued or bought back, dividends); net income also flows into retained earnings.
Exam shortcut
When a stem hands you an income statement, write the five subtractions in order before touching EPS. Circle the preferred dividend and the share-issue dates; answers built on year-end shares or on subtracting common dividends are traps. For any cash item, ask one sorting question: running the business, long-term assets, or owners and lenders? Depreciation is always added back. For filings, match the clue word.
The full lesson (about 5,172 words, 34 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- A2
Browse all free Series 65 lessons or jump into free Series 65 practice questions.